New York Markets After Hours

Going over fiscal cliff is best for bonds, but...

Investors don’t want outcome that would hurt companies

By

DeborahLevine

SAN FRANCISCO (MarketWatch) — A complete lack of agreement between Congress and the White House to soften the blow of expiring tax and spending measures at year-end would be the best scenario for Treasury bonds, potentially sending yields back to their all time lows.

GOP, Obama at odds on fiscal-cliff 'opening bid'

But most bond investors wouldn’t actually want that, not least because a recession could take a big toll on their coveted corporate debt holdings.

“The harder the cliff, the better off it is for the Treasury market which does better during bad economic times or uncertain geopolitical times because they benefit from a flight to quality,” said Gary Pollack, head of fixed income trading at Deutsche Bank AG’s private-wealth-management unit.

Bond investors understand it’s more likely that Congress and the White House will agree on a small number of tax and spending measures before the end of the year – just enough to convince markets the economy isn’t going over a fiscal cliff – but punt the larger issues down the road, probably to the middle or end of 2013.

That will likely be modestly negative for Treasury bonds, pushing yields up, and better for riskier types of fixed-income, including investment-grade and high yield bonds.

Municipal bonds are beholden to a somewhat separate debate about the exemption of interest from federal income taxes, or a cap on that exemption, but investors think the sector will continue to draw demand no matter what.

Fed backstopping economy

The primary concern for investors in all types of bonds will be how the deal struck in Washington affects the economy. They’re also watching the potential implications of the government running out of the ability to issue debt soon, and how rating agencies view the deal.

But regardless of what lawmakers do, bondholders know they have an ace up their sleeve: the Federal Reserve’s asset-purchase programs.

Consistent bond buying by the central bank has kept interest rates lower, and analysts broadly expect the Fed to continue purchases of Treasurys and mortgage backed securities into next year.

Congress and the White House “can construct something so that after the turn of the year, they provide a down payment of some sort and postpone the rest to revisit in six to nine months,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union. “I’m not too sure that would inspire a lot of confidence in markets.”

The market has priced in about $100 billion in fiscal tightening for 2013, according to analysts at Bank of America Merrill Lynch. Any deal that tightens more could push benchmark 10-year yields
US:10_YEAR
back to their record lows — around 1.40% seen in July — from about 1.63% Thursday.

A modest deal would, however, be considered significantly better than letting all the tax and spending measures expire, pushing the economy back into a recession. Relief from that may be enough to move markets.

“The most likely outcome will be some form of compromise, which will be beneficial for risky assets and a slight negative for Treasurys, so we’ll see yields rise,” Pollack agreed.

Investors didn’t have deep convictions about the importance of specific tax or spending measures being debated, but noted the reaction in bond markets will probably be closely linked to however stocks react and expectations of what the decisions mean for the growth outlook.

“The higher the growth outlook, the more negative for long-term Treasurys and positive for high-yield and emerging market bond and foreign currencies,” said Robert Tipp, chief investment strategist at Prudential Fixed Income Management.

The tone of the process will also matter, maybe as much as the actual line items that come out, he said.

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